Affiliated Funds Bias Affects Participants’ Accounts

A Pension Research Council working paper suggests there is
significant favoritism toward affiliated funds displayed by mutual fund
companies that act as service providers to 401(k) plans.

According to the report, researchers found affiliated funds are
more likely to be added and less likely to be removed from 401(k) plan fund
menus. The biggest relative difference between how affiliated and unaffiliated
funds are treated on the menu occurs for the worst performing funds, which have
been shown to exhibit significant performance persistence.

For example, mutual funds ranked in the lowest decile based
on their prior three-year performance have a deletion rate of 25.5% per year if
they are unaffiliated with the plan’s trustee. Similar-performing funds have a
deletion rate of just 13.7% if they are affiliated with the trustee. On the
other hand, funds in the top performance decile have a deletion rate of around
15% for both affiliated and unaffiliated trustees. “Protecting
poorly-performing funds by keeping them on the menu helps mutual fund families
to dampen the outflow of capital triggered by poor performance and, as a
result, mitigates fund distress,” the researchers write.

Veronika K. Pool, from Indiana University, Bloomington;
Clemens Sialm, from the McCombs School of Business at University of Texas at
Austin; and Irina Stefanescu, from the Board of Governors of the Federal
Reserve System, drove the research by hand-collecting information about the
menu of mutual fund options offered in a large sample of 401(k) plans for the
period 1998 to 2009, based on annual filings of Form 11-K with the U.S.
Securities and Exchange Commission (SEC). The sample includes plans that are
trusteed by a mutual fund family as well as plans with non-mutual fund
trustees. Most 401(k) plans in the sample adopt an open architecture whereby
investment options include not only funds from the trustee’s family (affiliated
funds) but those from other mutual fund families as well (unaffiliated funds).

In the data set, a given fund often contemporaneously
appears on several 401(k) menus that are administered by different fund
families, which provided researchers with a unique identification strategy and
allowed them to contrast how the very same fund is viewed across menus where
the fund is affiliated with the trustee and menus where it is not.

NEXT: The role of participant choice in fund bias.

The researchers noted that if 401(k) plan participants are
made aware of provider biases or are simply sensitive to poor performance, they
can, at least partially, undo favoritism in their own portfolios by not
allocating capital to poorly-performing affiliated funds. To test whether menu
favoritism has an impact on the overall allocation of plan assets, the
researchers examined the sensitivity of participant flows to the performance of
affiliated and unaffiliated funds.

What they found is that, consistent with studies documenting
that defined contribution plan participants are naive and inactive, the
participants in the sample were generally not sensitive to poor performance and
did not undo the menu's bias toward affiliated families. This in turn indicates
that plan participants are affected by the affiliation bias.

The researchers conceded it is possible that fund families
may also have superior information about their own proprietary funds, so
participants may show a strong preference for these funds not because they are
necessarily biased toward them, but rather, due to favorable information they
possess about these funds. To investigate this possibility, the researchers
examined future fund performance. That is, if despite lackluster past
performance, the decision to keep poorly performing affiliated funds on the
menu is information-driven, then these funds should perform better in the
future.

The researchers found this is not the case: affiliated funds
that rank poorly based on past performance but are not deleted from the menu do
not generally perform well in the subsequent year. They estimate that, on
average, these funds underperform by approximately 3.96% annually on a risk-
and style-adjusted basis. “These results suggest that the menu bias we document
in this paper has important implications for the employees' income in
retirement,” the researchers wrote.